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August 22, 2014

Rob Arnott Blasts ‘Smart Beta’ Imitators

Research Affiliates founder offers definition around a term threatened by ‘me-too’ firms applying the label to any strategy that is not cap-weighted

Many new products, Arnott and Kose write, purport to be "smart beta" when "frankly, they aren't!"

Maybe a rose by any other name would smell as sweet, but slapping the label “rose” on a skunk would not improve the impression the small mammal makes on those in proximity to its scent.

And that is the problem with the widely used new term “smart beta,” which generally has a positive connotation in the investment world but which is increasingly being applied to products with a rank smell — perhaps at least to Rob Arnott, whose firm, Research Affiliates, is most identified with smart beta.

In a newly published essay, Arnott, together with Research Affiliates senior researcher Engin Kose, wades into the fray on the true meaning of smart beta, which he views as “one of the most overused, ill-defined, and controversial terms in the modern financial lexicon.”

While Research Affiliates’ smart beta products have been commercially available now for close to 10 years, Arnott has perhaps been circumspect about defining a term that he makes clear was not his own invention.

So why speak up now?

“The success of so-called smart beta products has attracted a host of new entrants purporting to be smart beta products when, frankly, they aren’t!”

The fact that his own smart beta products — once derided as repackaged value investing based on back-tested data, he recalls — are just shy of 10 years of live data demonstrating their outperformance relative to cap-weighed indexing also suggests the need for a concrete definition of the strategy that has produced these results.

For starters, smart beta should not be understood as merely something other than traditional cap-weighted indexing. In fact, Arnott and Kose gallantly defend the rival indexing approach from charges that it is “dumb beta.”

“If an investor wants to own the broad market, wants to pay next to nothing for market exposure, and doesn’t want to play in the performance-seeking game, cap-weighted indexing is the smartest choice, by far,” they write.

Respectfully acknowledging the integrity of this strategy, Arnott’s worry seems to be the “me-too firms” that want to “stamp smart beta on anything that’s not cap-weighted indexing.”

Towers Watson, the investment consulting firm that coined the term smart beta, last year sought to add clarity to the term by defining it as “good investment ideas … structured better,” adding that such strategies should be “simple, low-cost, transparent and systematic.”

Arnott and Kose want to build on that definition, specifically with respect to equities. Here is their definition:

"A category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing."

This definition enables them to sharply contrast their approach to that of cap-weighted portfolios, whose indices are linked to price and therefore “automatically increase the allocation to companies whose stock prices have risen, and reduce the weight for companies whose stock prices have fallen.”

With this definition, Arnott and Kose generously include other investment strategies as meeting the standards of smart beta:

“Equal weight, minimum variance, Shiller’s new CAPE index, and many others, all sever this link, and empirically add roughly the same alpha,” they write, adding that all these approaches can be executed inexpensively and mechanistically, demonstrate historical and geographic efficacy and that some have “live experience that roughly matches the backtests.”

The live experience is an argument Arnott frequently cites, especially since the period during which his strategy has been implemented has generally been favorable to growth, though fundamental indexing’s value tilt has not prevented it from outperforming growth-oriented cap-weighted portfolios by about 2 percentage points.

In any event, Arnott maintains that breaking the link between price and weight is necessary but not sufficient to merit being called smart beta.

Rather, smart beta must also incorporate all or most of passive investing’s best features, itemized as transparent, rules-based, low-cost, liquid and well-diversified.

Arnott and Kose remind readers that smart beta is a long-term strategy wherein prolonged periods of underperformance must be expected. “Only a charlatan would encourage customers to expect 100% probability of future outperformance,” they write.

And while the future cannot be known in the present, they point out that their fundamentally weighted index has outperformed both a cap-weighted broad-market index and a cap-weighted value style index over the past 35 years.

Those traditional indexes will always be lower-cost than smart beta, but smart beta should in turn always be lower-cost than actively managed funds.

Financial advisors in particular are the ones who appreciate these distinctions, and see the wisdom in this middle approach. Write Arnott and Kose:

“The practitioner community has increasingly embraced the notion of seeking beta … for free, and paying for alpha.”

The source of smart beta’s alpha, they write, is the psychologically uncomfortable “contratrading” against investors who are buying what is popular and unloading what is unloved.

“Viewed in this context, smart beta actually can mean something useful: a smarter way for investors to buy beta with alpha," they write. "After all, if one can find a more reliable alpha, and pay less for it, that would be pretty smart.”